Holistic Regulation

“We must have a strategy that regulates the financial system as a whole, in a holistic way, not just its individual components.”

Ben S. Bernanke, “Financial Reform to Address Systemic Risk” at the Council on Foreign Relations, Washington, D.C., March 10, 2009

In a 2010 short paper, Brunnermeier, Hansen, Kashyap, Krishnamurthy and Lo (2010) argue that the field of economics has not adequately examined the topic of systemic risk. One of the reasons for this is that systemic risk is difficult to observe and quantify. The Office of Financial Research (OFR) is President Obama’s attempt to fill this gap in knowledge.

Even though systemic risk is poorly measured, that does not mean that economists haven’t thought of ideas to combat systemic risk. The Fed Chairman’s quotation citing the need for holistic regulation is one approach. Is a holistic approach to regulation a good thing? Today, I give my 2 cents.

Merits

Financial and economic market are complex entities. Creating multiple government bodies where each one only regulates a piece of a given market can often be suboptimal. An individual agency may be in charge of making a given financial instrument safer or more transparent. Even if they government body succeeds in their mission, their regulations may create unintended consequence. For instance, another, more volatile, less transparent, unregulated financial instrument is created. Or the regulation could have an adverse effect on real markets. Having a single entity regulate all financial markets in an integrated fashion seems like a promising idea.

Problems

However, regulation generally requires more specialized knowledge than any one agency can maintain. For instance, credit default swaps are complicated entities. Regulators must have specific knowledge in order to properly regulate these instruments. Having a single body regulate all financial markets may create an entity with a wide breadth of knowledge but little depth. Further, if the regulatory scheme created by the central planner is poorly constructed, investors may have no other markets from which they can seek more rational regulation. If regulation by some of the government bodies is successful, investors could migrate to investments in more rationally regulated sectors (although this shift from well-regulated to poorly-regulated markets is a distortion in and of itself).

Motivation

In addition, one has to question the Chairman’s motivation for expanded regulation. He may have the best interests of the country at heart; integrated regulation may be the best mechanism through which one can decrease systemic risk. However, Dr. Bernanke is not an unbiased observer. Centralizing regulatory control increases the power of the Fed, the and the prestige of Dr. Bernanke. Thus, the desire to centralize regulation may not be a completely unbiased opinion.